As interest rates remain at their highest levels in over two decades and inflation continues to exert pressure on consumers, major banks are bracing for potential risks linked to their lending operations.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions represent funds set aside by financial institutions to mitigate potential credit risk, which includes delinquent debts and various types of loans, particularly commercial real estate (CRE) loans.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America allocated $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion by the end of the quarter, significantly more than its previous quarter’s reserve. Wells Fargo made provisions of $1.24 billion.
These increased reserves reflect the banks’ caution in a challenging economic environment where both secured and unsecured loans pose a heightened risk of larger losses. A recent study by the New York Federal Reserve revealed that U.S. households collectively hold $17.7 trillion in consumer loans, student loans, and mortgages.
Moreover, credit card issuance and delinquency rates are rising as individuals deplete their pandemic savings and turn increasingly to credit. In the first quarter, credit card balances surpassed $1 trillion, marking the second consecutive quarter this threshold was exceeded, according to TransUnion. The position of CRE loans also remains uncertain.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, stated, “We’re still coming out of this COVID era, particularly regarding banking and consumer health, which was significantly influenced by the stimulus provided to consumers.”
However, potential issues for banks may emerge in the upcoming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, explained that current provisions reflect expectations for future credit quality rather than merely past performance.
He added, “Historically, when loans began to default, provisions would increase, but we have shifted to a model where macroeconomic forecasts heavily influence provisioning decisions.”
Looking ahead, banks foresee sluggish economic growth, rising unemployment, and anticipated interest rate cuts later this year in September and December. This scenario could lead to an increase in delinquencies and defaults as the year progresses.
Mark Mason, Citigroup’s CFO, indicated that the warning signs are predominantly observed among lower-income consumers, who have seen a decline in their savings since the pandemic.
“While we observe overall resilience in U.S. consumers, we note a divergence in performance based on FICO scores and income levels,” Mason stated during a recent analyst call. “Our data shows that only the highest-income quartile has maintained increased savings since early 2019, predominantly among consumers with FICO scores over 740, who are driving spending growth and upholding high payment rates. In contrast, consumers with lower FICO scores are experiencing a notable decrease in payment rates and are borrowing more due to the impact of inflation and rising interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of 5.25% to 5.5%, awaiting stabilization in inflation rates towards the central bank’s target of 2% before implementing the much-anticipated rate cuts.
Despite the banks’ preparations for increased defaults in the latter half of the year, Mulberry notes that defaults have not yet escalated to a level indicative of a consumer crisis. Currently, he is observing the differences between homeowners and renters during the pandemic period.
“Although interest rates have risen significantly, homeowners secured low fixed rates on their debt, so they are generally not feeling the financial strain,” Mulberry explained. “Renters, however, who did not benefit from these conditions are facing substantial challenges.”
With rentals increasing by over 30% nationwide between 2019 and 2023 and grocery costs rising by 25% in the same timeframe, renters are experiencing heightened pressure on their monthly budgets, according to Mulberry.
For the moment, however, the key takeaway from the recent earnings reports is that there were no new concerning trends regarding asset quality. Positive indicators such as strong revenues, profits, and resilient net interest income signify the continued health of the banking sector.
Mulberry remarked, “There are strengths in the banking sector that may not have been entirely unexpected, but it is reassuring to see that the financial system remains robust and sound at this time. However, we are closely monitoring the situation, as prolonged high-interest rates will create additional stress.”